Used wisely, low interest rates are a boon

Bankers are up to their old sneaky tricks, with researcher RateCity claiming this week that some lenders have been contacting mortgage borrowers encouraging them to spend any extra cash rather than paying down their home loan.

Yes, in an era where austerity is the new black, lenders (along with retailers) want us to splash our cash rather than joining the global push to reduce debt.

RateCity says some borrowers with savings sitting in their home loan are being told they can absorb their savings by paying less than the minimum home-loan repayment.

For example, if you have $500 in savings on your home loan, you might be offered the option of paying $1983 a month on your mortgage instead of the normal $2000, with the difference deducted from your savings.

It's hard to say no to a bit of extra cash in hand (especially if you've just received a monster electricity bill), but as RateCity points out, the lenders don't have your interests at heart in making these suggestions. With lending growth slow, they want to hang on to every mortgage loan dollar they can. But in uncertain times, it pays to be debt-smart.

While Australian households have stopped loading up on debt, figures from the Reserve Bank show household debt is still running at about 150 per cent of disposable income. But thanks to lower interest rates, servicing that debt is taking up less of our precious income - about 11 per cent versus the peak of almost 14 per cent.

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We're also saving more. While the household savings ratio has fallen back to less than 10 per cent (it peaked at about 13 per cent in the wake of the global financial crisis), it is still well above the levels seen in much of the 1990s and early 2000s.

That's the good news. The bad news, as the graph shows, is that we haven't been deleveraging so much as standing still.

And while interest rates are low now, higher rates would soon put pressure on borrowers who have overextended.

With official interest rates at a low 3.5 per cent, borrowers have the ideal opportunity to reduce their debt and build a buffer against future rate rises - exactly the opposite of what lenders suggest.

Debt, of course, isn't necessarily a bad thing. Effectively used, it can be a powerful tool for building wealth and providing financial security. But too many of us were encouraged into bad habits during the boom and are continuing to fall for the bad debt traps. Here's just a few of them.

More is better

The introduction of responsible lending laws should hopefully curb the worst excesses of lenders, but just because someone will lend you $X, it doesn't mean you should take it. Lenders are in the business of selling loans. It's their job to sell as much debt as they can arguably justify that you can afford. Borrowers need to make their own decisions about how much debt they should take on.

Focus on the home loan

It's your biggest loan so it's the one you should work on, right? Actually, no. Credit card and personal loan interest rates can be at least double what you pay on your home loan and that debt arises from things that have probably already fallen in value or been consumed, such as a holiday. Your mortgage may be your biggest debt, but you've borrowed the money to buy something that should increase in value. Save real money and get rid of those expensive, non-value debts first.

On the other hand, if you have tax-deductible debts, such as investment loans, and no expensive personal debt, it makes good sense to focus on paying off your non-tax-deductible mortgage first.

The equity trap

Many borrowers now have redraw facilities or other ways of drawing down on their home equity to fund lifestyle purchases. Again, this can appear appealing.

Why pay 14 per cent or more on a new car loan when you can just draw down your mortgage to fund that new set of wheels at about half that rate?

But it can soon turn out to be false economy. That 14 per cent loan will be structured to be repaid over a limited period - usually five years. But if you wrap it up in your mortgage, you could be paying interest on your car long after you've ceased owning it.

Keep the redraw facility for genuine emergencies or for investment borrowings designed to build wealth - as long as you can keep your personal and investment borrowings separate for tax purposes.

Minimum payments

The new credit card rules require lenders to show on monthly statements how long it will take to pay off the loan if you just make the minimum payment.

A good thing too, as it can take forever. The minimum payment hasn't been devised to ensure you pay off your debt; it's simply there to cover your interest and a minimal principal repayment.

Revaluing to borrow more

Remember ABC Learning and other companies that went bust by gearing up based on unrealised increases in the value of their existing assets? Some investment-property and margin-lending schemes suggest you follow exactly the same route to ''success''.

While using existing equity to grow your investment portfolio can be a good thing, beware of strategies based on aggressive revaluations and borrowing.

Those gains aren't in your pocket unless you sell the investment, but the debt will always be there.